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Tax Law No. 02-60188, 4/16/2003. Click here for the full text of this decision FACTS: The court considers the appeal of the Tax Court’s decision against the appellant, Blue Cross and Blue Shield of Texas Inc. and Subsidiaries. The issues in this appeal require resolution of whether certain amounts referred to as “coordination of benefits savings” (COB savings) qualify as “estimated salvage recoverable” such that Blue Cross can claim a special tax deduction, and, if not, whether Blue Cross met requirements to fall under a safe harbor provision entitling it to the deduction. The special deduction at issue allowed insurance companies to deduct ratably over a four-year period 87 percent of estimated salvage recoverable as calculated at the end of tax year 1989. Blue Cross claimed the deduction for years 1992 and 1993 based on an amount of “salvage recoverable” that consisted mostly of COB savings and, the IRS subsequently denied the deduction after an audit. Blue Cross challenged the IRS’ position denying the deduction. The Tax Court held that Medicare related and non-Medicare related COB savings amounts did not qualify as estimated salvage recoverable so as to be the basis for a special deduction. Additionally, the Tax Court held that Blue Cross did not meet the requirements to fall under the safe harbor provision. HOLDING: Affirmed. The term “estimated salvage recoverable”is not defined in the Tax Code. The term appears in Internal Revenue Code �832, 26 U.S.C. �832(5)(a), which outlines the procedure to calculate “losses incurred,” a deduction for federal income tax purposes. Under this statute, estimated salvage recoverable is one component used in the calculation to determine the appropriate amount of the deduction for losses incurred. Prior to 1990, �832 required only paid lossesto be reduced by salvage recoverable. However, in 1990 Congress amended �832 by �11305(a) of the Omnibus Budget Reconciliation Act of 1990, now requiring that paid and unpaidlosses be reduced by estimated salvage recoverable, whether or not the salvage is treated as an asset for statutory accounting purposes. In other words, prior to 1990, salvage recoverable was only used to calculate paid losses for the “losses incurred” determination; after 1990, salvage recoverable is used to calculate paid and unpaid losses for the “losses incurred” determination. Because “estimated salvage recoverable” is a subpart of paid and unpaid losses, definitions and interpretations of paid and unpaid losses are instructive on the scope of “estimated salvage recoverable,” as well as explanations of the concept of salvage in general. In fact, such definitions and interpretations are the only sources for determining what “estimated salvage recoverable” means, and whether it should include COB savings under a pursue and pay approach. “Salvage” in the insurance context is “the property saved or remaining after a fire or other loss, sometimes retained by an insurance company that has compensatedthe owner for the loss.” “Black’s Law Dictionary”, Seventh Edition (1999). The U.S. Supreme Court described the general concept of salvage in the following way: “From the very nature of the contract of insurance as a contract of indemnity, the insurer, when he has paid to the assuredthe amount of indemnity agreed on between them, is entitled by way of salvage, to the benefit of anything that may be received, either from the remnants of the goods, or from damages paid by third persons for the same loss.” Phoenix Ins. Co. v. Erie & Western Transp. Co., 117 U.S. 312 (1886). Specifically in the context of paid losses, courts have considered the terms salvage and salvage recoverable in cases decided prior to the 1990 amendment. One court explained that “when an insurance company pays a claim, it ordinarily has a right of salvage under the insurance policy.” Allstate Fire Ins. Co. v. United States, No. 381-73 (Ct. Cl. Mar. 14, 1980). Another case pointed out that “salvage includes all tangible property and subrogation claims acquired by an insurance company after indemnifying its insured under contracts of insurance.” Continental Ins. Co. v. United States, 474 F.2d 661 (Ct. Cl. 1973). In Continental, the court explained that in calculating paid losses, salvage in the course of liquidation, consisting of all property, real or personal, and tangible or intangible, shall be taken into account to the extent of the value thereof at the end of the taxable year as determine from a fair and reasonable estimate based upon either the facts of each case or the company’s experience with similar cases. These cases suggest that salvage recoverable, at least in the context of paid losses, includes amounts the company reasonably expects that it will recover after it has paid a claim. In the context of unpaid losses, courts have not considered the meaning or scope of “estimated salvage recoverable.” However, Income Tax Regulation 1.832-4 directly addresses the calculation of “unpaid losses” for the purpose of determining losses incurred, and estimated salvage recoverable is a part of that calculation. The authority explaining/defining salvage, estimated salvage recoverable in the context of paid losses, and the regulation regarding unpaid losses all support the Tax Court’s holding that estimated salvage recoverable does not include COB savings under the pursue and pay approach because there is no expectation of payment of the full amount and, accordingly, no corresponding salvage right. The fact that some of the COB savings were Medicare related does not change the outcome – even if Blue Cross provided coverage for such claims, the Medicare related claims were handled in the same way as other claims with regard to the pursue and pay approach. Consequently, Blue Cross similarly had no expectation of paying amounts covered by Medicare as a primary plan, but would only pay the remainder of the claim after payment by Medicare in accordance with its “other coverage” provisions. Thus, no estimated salvage recoverable existed with regard to the Medicare related COB savings for the same reasons as non-Medicare related COB savings. A determination of whether Blue Cross’ policies excluded all claims covered by Medicare or just amounts paid by Medicare is not necessary, but such a finding would only add support to the conclusion that Medicare related COB savings do not constitute estimated salvage recoverable. Blue Cross argues that it is entitled to the deduction under the safe harbor provision even if COB savings do not qualify as estimated salvage recoverable because Blue Cross was in good faith and acted without fraud in claiming the deduction. Adoption of the “absence of fraud” standard as Blue Cross argues it should be applied, would result in a safe harbor provision that allowed companies to take a deduction for items that were not under the law “estimated salvage recoverable,” but nonetheless would qualify for the benefits as such because the claiming party believed in good faith that such items were estimated salvage recoverable. A safe harbor should not be applied in such a way that it results in changing the legal status of an item; rather, safe harbor provisions should be applied to allow parties to qualify for a benefit despite technical errors in the amount claimed, not the item claimed. Therefore, whether the standard is bona fide or absence of fraud, the safe harbor provision should be applied to protect discrepancies in amounts claimed, not items. Because Blue Cross did not claim items that legally constitute estimated salvage recoverable, it is not entitled to the deduction on the sole basis that it believed in good faith and without fraud that such items were estimated salvage recoverable. Applying the safe harbor in this way leads to the conclusion that the standard was not changed, but only clarified to reflect the purpose of a safe harbor provision. OPINION: Fallon, J.; DeMoss, Stewart and Fallon, JJ.

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